What are Security Tokens? A Guide for Professionals

What are Security Tokens? A Guide for Professionals

What are Security token?

Security tokens are tokenized assets, securities, or an ownership position representing a position in a corporation, a creditor relationship with a government, or rights to ownership as represented by equity or option. A security token is a tokenized, digital form of these traditional securities. 

Let us understand more about security tokens by splitting the term into two parts and analyzing them separately. In the first part, security means “a certificate attesting the ownership of stock or bonds or the right to ownership connected with tradable derivatives”.

In the second part, tokens are anything tangible that represents any other object which can be both physical and virtual. Tokens that represents anything of value on the blockchain. Security tokens are generated through a process called the Security Token Offering (STO) that will be discussed later in the article. They are used to raise funds as a source of corporate finance.

What is Security Token Offering (STO)?

The investors are issued tokens in exchange for their investment. It is similar to Initial Coin Offering (ICO) in most ways, but, a security token is used for investments on assets like stock, real estate investment trusts and bonds. Security Token Offering is considered to be the hybrid of ICOs and the “traditional Initial Public Offering” because it adapts the investment raising methods used in both of those.

Security Tokens Offering (STO) are subject to regulations more than Initial Coin Offerings and so they are considered to be a better investment alternative than ICO, when looked from the safety aspect.

There are 88 Security Token Offering projects that are identified globally. The company tZero has raised over $130 million, which is the highest STO so far. The success rate of STO projects is roughly estimated to be around 50%.

Differences between a security token and a utility token

Security tokens are issued mainly for investments. Dividends to the token owners are given in the form of additional tokens. The holders of the security tokens get ownership of the company. On the other hand, utility tokens do not give their holders get ownership of the company, they are only used to avail the company’s products and services.

The Howey Test

This is a test that helps us differentiate between a security token and a utility token. This test concludes that a token will be a security token if it satisfies the following two criteria:

  • There should be an investment of money, invested in a “common enterprise”.
  • The profits are expected mainly from the efforts of individuals other than the founders of the company.

Advantages of security tokens 

  • Security token grants access to their owners all time of the day, everyday (24/7) unlike the stock market which has time restrictions for trading. This helps the investors to act in a timely manner to the changes in the market.
  • Security tokens enable fractional ownership, this lowers the minimum investments. This makes the market more liquid. Since, many people can buy smaller stakes, the liquidity of assets increases in the blockchain system.
  • Security tokens enable a more accurate valuation of assets. This is due to a more free and competitive market.
  • Financial transactions are usually expensive because of the money spent on the middlemen such as the banks. Security tokens help and remove the middlemen in such transactions and thus removing the money spent on them.
  • Security tokens speeds up the financial transactions by eliminating the middlemen. This makes security tokens a more attractive form of investments.
  • The general uses of the security tokens usage:-
    • It makes the process of accounting and auditing very simple.
    • It minimizes the complexity in the managing of securities.

Disadvantages of security tokens

  • Non-accredited investors can not own security tokens. Non-accredited investors are those who fail to meet the Securities and Exchange Commission (SEC) income requirements to be accredited investors 
  • Security tokens help in removing the middlemen. This makes people unemployed because the number of jobs in banking institutions reduces. Many consider that companies will be unsuccessful without the help of “traditional institutions”.
  • Security token offering has been taking place very recently. So, it has not been tested in the long term yet. This makes security tokens riskier to both the business and the investors.
  • If the security token is stolen or lost, it cannot be used to avail a service. If it is hacked, vital information may be misused. 

ICO –Initial Coin Offering

Companies use Initial Coin Offering (ICO) to raise the required funds to create a new coin, app or service. Investors, who are interested in investing in the company, invest in the Initial Coin Offering in exchange for a cryptocurrency token. This token can be used to represent the shareholdings of the investors and may also contain some utility in the product of the company. The company’s products usually include goods and services that are related to cryptocurrency and blockchain. 

The companies create a “whitepaper” which describes the project, the purpose, the need for it and it aims to carry out. It also has the information about the funds it will be necessary, the number of “virtual tokens” it will keep and the duration for which the Initial Coin Offering campaign will take place. The people interested in the project, buy the tokens by paying fiat or digital currency. If the fund raised within the duration of the campaign meets the minimum fund amount criteria, then the amount if utilized by the company for the said purpose. If the minimum criterion is not met within the duration of the campaign, the amount will be returned to the investors.

The investors must be very careful because the Initial Coin Offering (ICO) is completely unregulated; there are high chances for them being cheated. Though the ICOs are unregulated, SEC (Securities and Exchange Commission) can overlook it. The companies must have a cryptocurreny wallet, as the investors buy the tokens with cryptocurrencies that already exist.

The future of security tokens

Presently, the majority of the tokens in the market are utility tokens, but soon enough in the coming years, the share of security tokens will be larger considering that they are safer than utility tokens due to the strict regulations. Wall Street and many others would start turning their attention towards security tokens and there would be a larger flow of investments.

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  • Wow, very nice article. Good information about security tokens for me, keep rocking Dharshini.

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